Circular Sales (#395)

ABP #395 - Circular Sales

Steven Bragg

What is a Circular Sale?

A circular sale occurs when two parties buy from and sell to each other in transactions that lack a clear economic substance. The arrangement is designed to create the appearance of revenue, usually to boost the stock prices of the companies. This is considered accounting fraud.

One of the largest examples of this was Qwest Communications, based in Denver, Colorado, back in 2001. In one case, Qwest entered into a swap arrangement with Global Crossing, where each party swapped fiber optic network capacity, and both recorded revenue from the swap. The SEC forced Qwest to reverse that transaction, which eliminated $63 million of revenue. And that was not the only swap arrangement that Qwest entered into. In total, Qwest had to reverse $950 million of revenue from these swap deals.

So the issue here is that sales are essentially being manufactured without any concrete underlying business activity.

AI Industry Funding Arrangements

Now, let’s move forward to today, and look at what’s going on in the AI industry. Nvidia has stated that it’s going to invest up to $100 billion in OpenAI, which OpenAI will then use to fund a data center build out, which in turn uses massive amounts of Nvidia chips. In addition, there’s the initial $5 billion Amazon investment in Anthropic, which could go up to $20 billion. In the Anthropic situation, it plans to spend the money on compute time from Amazon Web Services, or AWS. I’ll focus on the Amazon deal.

Circular Sales Analysis

At first, this looks circular. Amazon puts money into Anthropic, and Anthropic commits to spend money on AWS. AWS may then report revenue from those cloud services. So the question is whether Amazon is, in effect, funding its own future sales.

That’s the right question, but the answer is not automatically yes. There’s an important distinction between a circular sale and a strategic customer-supplier relationship. Amazon is not buying cloud services from Anthropic and then having Anthropic buy the same services back. Instead, Amazon is investing in a company that needs a lot of computing capacity, while Anthropic is committing to buy capacity from one of the world’s major cloud infrastructure providers.

So the accounting issue is more subtle. It’s not, “Are the same goods being passed around in a circle?” That’s not going on. Instead, the issue is, “Are the investment and purchasing commitments so economically linked that some portion of the reported revenue should be viewed as funded by the vendor rather than earned from an independent customer relationship?”

There are a couple of indicators to examine.

The first is commercial substance. Does Anthropic have an independent business reason to buy AWS compute time? The answer appears to be yes. AI models require vast amounts of computing power. Anthropic trains and serves Claude models, and it needs infrastructure to do so. That supports the argument that the purchases are operationally necessary, rather than merely a device for moving money back to Amazon.

The second indicator is pricing. Are Anthropic’s AWS purchases priced at market rates, or are they priced in a way that embeds the investment return into the service arrangement? If AWS charges normal commercial prices, then that supports revenue recognition. If the pricing is inflated because Amazon first supplied capital, then the arrangement begins to look more like a financing loop. There’s not enough publicly-available information to determine this.

The third indicator is enforceability. Is Anthropic obligated to buy a fixed amount of AWS services regardless of need? If so, the arrangement wouldn’t automatically be circular, but it would require more analysis. You would need to understand the rights and obligations of both parties.

The fourth indicator is collectability. If a customer can pay for services only because the vendor invested in the customer, then collectability becomes more complex. This does not necessarily eliminate the possibility of revenue recognition, but it raises the question of whether Amazon is effectively financing Anthropic’s purchases. In that case, the accounting analysis may need to separate revenue from any financing effects.

The fifth indicator is whether there are side agreements. Circular sales frequently depend on informal commitments that are not obvious from the main contract. For the Amazon-Anthropic relationship, the public announcements describe a strategic collaboration and an investment. They do not provide the full contracts. Without those contracts, no outside observer can make a definitive accounting conclusion.

So, does the circular sales concept apply? Well. It’s reasonable to ask whether Amazon is investing in Anthropic partly to create future AWS revenue. But does that mean the arrangement is a circular sale in the classic fraudulent sense? Based only on public information, no. The arrangement has several features that differ from a circular sale. Anthropic appears to need the compute time. AWS appears to be capable of providing a real service. The service is not being resold back to Amazon as the same item. And there is an identifiable business purpose: Amazon wants a major AI model developer using AWS, while Anthropic wants guaranteed large-scale computing capacity.

The key takeaway is to avoid treating the deal as either completely ordinary or automatically abusive. It sits in a gray zone that requires a detailed contract-level analysis. The questions should include: Are the AWS service fees at the market price? Are there any minimum purchase commitments? Are future Amazon investments contingent on Anthropic’s AWS spending? And does Amazon recognize revenue only as it satisfies real performance obligations?

In short, circular sales are about substance over form. They occur when reciprocal transactions create the appearance of sales without genuine outside demand. The Amazon-Anthropic arrangement does not appear to be a textbook circular sale. But it absolutely raises the kind of questions that circular-sale analysis is designed to address. When a vendor invests billions in a customer, and that customer commits to spend a huge amount with the vendor, then you certainly should look at the substance behind the revenue.

That is the real lesson. Not every reciprocal arrangement is a circular sale. But every major investment-linked purchasing commitment deserves a hard look before its revenue is treated as ordinary, independent customer demand.

Accounting for Internal-Use Software (#394)

ABP #394 - Accounting for Internal-Use Software

Steven Bragg

Changes to the Accounting for Internal-Use Software

The accounting for internally-developed software used to be built around project stages, where costs could be capitalized once you reached a certain development stage. That worked fairly well when software development followed a linear path from start to finish. But projects don’t always work that way anymore. Project cycles tend to be a lot shorter, with lots of incremental releases. This makes it more difficult to use the old guidance.

The new guidance replaces the old approach entirely, and uses a fairly simple recognition threshold to decide when to capitalize development costs. In essence, you start capitalizing only when two conditions are met. First, management has authorized and committed to funding the project. Second, it’s probable that the project will be completed and that the software will be used for its intended function. That second condition can be difficult. The standard says that capitalization cannot begin if there is significant development uncertainty. In effect, you have to determine whether the project is still too uncertain to justify putting development costs on the balance sheet.

There are two indicators of development uncertainty. One is technological uncertainty. If the software includes technological innovations or novel, unique, or unproven features, and that uncertainty has not yet been resolved through coding and testing, then the project has not yet crossed the capitalization threshold. The other indicator is uncertainty about performance requirements. If you haven’t yet identified what the software needs to do, or if those significant requirements are still being substantially revised, then capitalization has to wait.

So, the accounting model is now more focused on substance than on labels. Instead of arguing about whether a project has officially entered an application development stage, you simply have to ask, have we committed to this project, and have we reduced the uncertainty enough that completion is probable?

That change is especially important for agile development. Under older guidance, agile teams often had trouble pinpointing when one stage ended and another began, because planning, coding, testing, and revision can all overlap. The new model is designed to work better in that environment by focusing on the threshold for recognition rather than on a rigid sequence of stages.

Even so, any costs incurred before the capitalization requirements are met have to be expensed as incurred. Early conceptual work, such as feature discussions, unresolved technical issues, and other uncertain development efforts are all expensed until the recognition threshold has been reached.

Once the threshold is met, the list of capitalizable costs is fairly specific. It includes the external direct costs of materials and services used to develop or obtain the software. It includes the payroll costs for employees who are directly associated with the project, but only for the time they spend directly on it. It also includes the costs to develop or obtain software for the conversion of old data for the new system.

There are also some costs that are not capitalized. Training costs are expensed as incurred. General and administrative costs are not capitalized. Maintenance is expensed as incurred. So, capitalization is not a blanket rule for all project spending. It applies only to eligible items.

This means that project accounting becomes very important. You have to distinguish between direct software development activities and all the surrounding activities that may support a project but do not qualify for capitalization. Without good time tracking and vendor invoice coding, it becomes much harder to apply the guidance correctly.

And then there’s the issue of upgrades. If a modification gives the software additional functionality, then those costs can be evaluated for capitalization under the same general model. If you can’t separate maintenance from minor upgrades on a reasonably cost-effective basis, then you should expense those costs as incurred. And, if an outside contract combines maintenance with upgrades, then the contract cost has to be allocated so that the maintenance element is charged to expense.

Capitalization ends when the software is substantially complete and ready for its intended use. This point is reached no later than the completion of all substantial testing. After that point, further costs are generally expensed, unless they qualify as a separate enhancement.

There is also an impairment dimension. If it later becomes no longer probable that the software project will be completed and placed in service, then no further costs are capitalized. At that point, you have to evaluate the existing asset for impairment.

There are some warning signs for this, including a lack of project spending, programming problems that can’t be resolved on a timely basis, significant cost overruns, or a decision to switch to third-party software instead of finishing the internally developed system.

This guidance also applies to the development of a website. For example, any fees paid to develop a website can be capitalized once the recognition threshold is met. It might also be possible to capitalize the cost of the initial graphics for the site. But search engine registration costs are treated as advertising and expensed right away, while website hosting fees are also expensed over the usage period.

The basic lesson here is that software capitalization is no longer driven by a checklist of project stages. Instead, it’s driven by a recognition threshold. Management has to authorize and commit to a project, and it has to be probable that the project is going to be completed. If there are major technical uncertainties, or if the requirements are still unsettled, then capitalization has to wait.

Accounting for Cannabis (#393)

ABP #393 - Accounting for Cannabis

Steven Bragg

This episode covers the unique issues related to the accounting for cannabis. Many boards of accountancy have issued statements about how CPAs should deal with clients in this business. I’m going to quote from a statement issued by the Arkansas Board of Accountancy, which is pretty representative: “The provision of professional services within states where medical marijuana has been legalized to clients that are properly licensed… does not constitute a violation of Board rules regarding good moral character or acts discreditable to the accounting profession. However, federal law still prohibits the sale, possession, growth, and distribution of marijuana. The Board could possibly take action if a licensee was convicted of a crime related to medical marijuana.” In other words, you can provide services to this industry, but do not get caught using it.

The Classification of Cannabis

At first glance, this might seem like a fairly ordinary industry accounting topic. A cannabis business has sales, and payroll, and rent, and pays taxes, just like any other business. But the real challenge is that the federal government still classifies marijuana as a Level 1 controlled substance. A cannabis business may be completely legal under state law and still face federal tax treatment that’s much harsher than what applies to most other industries.

Tax Treatment of Cannabis Businesses

That federal tax treatment revolves around Internal Revenue Code Section 280E. That section prohibits businesses engaged in the "trafficking" of Schedule I or II controlled substances from deducting "ordinary and necessary" business expenses from their federal taxable income. This means that cannabis businesses are generally denied the normal federal income tax deductions that most companies take for ordinary operating expenses. This creates a very large difference between book accounting and tax accounting.

From a financial statement perspective, a business still records its transactions in the usual way. It recognizes revenue when earned, records wages when incurred, depreciates fixed assets, and so on. So if you looked only at the books, the situation might appear fairly conventional.

But then we have the tax rules.

Under Section 280E, a cannabis business cannot deduct expenses like rent, payroll, marketing, office expenses, and overhead to reduce book income for federal tax purposes. The one major exception is the cost of goods sold. The IRS takes the position that Section 280E does not prohibit a business from reducing gross receipts by a properly computed cost of goods sold. That point is critical.

If you operate a normal retail business, you usually focus on gross margin, operating margin, and net income. In a cannabis business, those measures still matter, but the real pain point is that taxable income can be far higher than book income. A company may report only a modest accounting profit, or even an accounting loss, after considering all of its operating expenses, and yet still owe a large amount of federal income tax because so many of those expenses are nondeductible under 280E.

This is why the accounting department in a cannabis business has to pay close attention to cost classification.

Cost Classifications

Management needs a chart of accounts that clearly separates direct production expenses, inventory-related overhead, retail expenses, administrative expenses, and selling expenses. The more precise that classification is, the easier it is to determine which expenditures can flow into inventory and then into the cost of goods sold, and which ones will remain ordinary operating expenses that will be disallowed for federal tax purposes.

For cultivators, this means that inventory accounting is massively important. They may have direct materials, direct labor, production supervision, utilities for growing facilities, and other expenditures that can be capitalized into inventory. For dispensaries, the ability to capitalize costs is way more limited, which is why the federal tax burden can be especially severe for them.

In short, inventory accounting becomes a tax survival issue.

This also means the monthly close has to do more than produce financial statements. The accounting staff should prepare supporting schedules that reconcile book income to taxable income, identify the Section 280E adjustments, and document exactly how the cost of goods sold was calculated.

If those schedules are incomplete or inconsistent, the business is exposed not only to higher taxes, but also to an audit.

The Need for Three Sets of Books

Another issue is budgeting. In most industries, management can take pretax book income, adjust for a few tax differences, and arrive at a reasonable tax estimate. That approach does not work well here. In a cannabis company, the difference between book income and taxable income can be massive. So the accounting department has to forecast taxes very carefully. Otherwise, you may think the company has enough cash to fund its operations, and then discover that a large tax payment is coming due because federal deductions were denied.

This can create a strange financial profile. A cannabis business may appear operationally sound, with decent revenue and gross margins, while still struggling with cash flow because its effective tax rate is wildly high.

Now let’s turn to the state side of the issue, because state-level deduction rules are completely different. Many states use federal taxable income as the starting point for the state tax return. If a state conforms to federal law and does not provide any special relief, then the federal 280E problem effectively carries over into the state return. That means the business can lose deductions at both the federal and state levels.

However, some states have chosen to decouple from Section 280E for licensed cannabis businesses. When a state decouples, it allows some or all of the deductions that federal law disallows. This creates a very different state tax result from the federal one, even though both returns are based on the same underlying accounting records.

Colorado is a good example. It allows a subtraction for normal business expenditures, which provides relief on the Colorado return for licensed cannabis businesses. Oregon and California do the same thing.

By contrast, in states that conform more closely to federal taxable income, the 280E burden is mostly intact at the state level. And in states without a traditional income tax, such as Washington, the issue shifts elsewhere, because the business may instead be dealing with larger amounts of excise taxes, sales taxes, and business activity taxes rather than a state income tax.

So from an accounting standpoint, the business needs a multi-layered tax model. First, it needs clean financial statements that are prepared under normal accounting principles. Second, it needs a federal tax framework that’s built around Section 280E, with strong documentation for the cost of goods sold.

And third, it needs a state-by-state tax analysis showing where deductions are allowed, where they are disallowed, and how state conformity rules differ across jurisdictions. So, that’s three sets of books.

The result is that cannabis accounting is really two jobs at once. One job is to produce accurate financial records. The other is to translate those records into a tax structure that reflects both federal 280E restrictions and state-level deduction rules. In short, a bookkeeper in this industry is set for life.

IT Auditors (#392)

ABP #392 - IT Auditors

Steven Bragg

What IT Auditors Do

An IT auditor examines the systems and controls that an organization relies on to process information, protect data, and support operations. The goal is not just to determine whether the technology works. The goal is to determine whether the controls surrounding that technology are designed properly and operating effectively. In other words, the IT auditor wants to know whether the organization’s systems are secure, reliable, and well managed. Which is frequently not the case.

There’s a wide range of work. For example, an auditor might review user access controls to see whether employees have access only to the systems and data that they need. The auditor might test change management controls to confirm that software updates have been properly tested and rolled out. Or, the auditor might examine backup and recovery procedures, in case any databases are corrupted.

A useful way to think about IT auditing is that the auditor is asking three questions. First, what could go wrong? Second, what control is supposed to prevent or detect that problem? Third, how do we know that the control is actually working? That approach makes IT auditing both technical and methodical. It’s technical because you have to understand the underlying systems. It’s methodical because the work depends on very careful documentation and testing.

Now, some people hear the word “auditor” and assume the role is narrow or repetitive. In reality, IT auditing can be extremely varied. One week you might be interviewing system administrators about system access privileges. The next week you might be reviewing system-generated logs, testing a password configuration, mapping an application process, or writing a report that goes to the audit committee. The work involves investigation, critical thinking, and communication, not just working your way through a checklist.

How Do You Enter the Field?

There is no single path, which is why the field attracts a broad range of people. Some start on the accounting or internal audit side and then specialize in technology-related controls. Others begin in information technology, cybersecurity, or systems administration and then move into audit.

A college graduate with a degree in accounting, information systems, or business analytics can potentially enter the field through an internal audit department, or a public accounting firm, or a consulting firm, or some kind of corporate risk function.

A common entry point is through internal audit. Many larger organizations have internal audit teams that include specialists in IT controls and cybersecurity risk. Another common path is public accounting or advisory work, where the staff may help clients evaluate things like application controls, system access, or change management. Some people also enter from the operational side after working in help desk support, system administration, or information security. That experience can be valuable because it helps you understand how systems actually function in the real world.

For someone trying to break in, internships can be useful. So can entry-level roles in audit, compliance, risk, cybersecurity governance, or IT operations. Even if the first role is not labeled “IT auditor,” it may build relevant experience. What matters is exposure to systems, controls, policies, documentation, and risk assessment.

Qualifications

At a minimum, most employers want a solid understanding of information technology concepts and control principles. That does not always mean that you have to be an expert programmer or a network engineer. In many IT audit roles, the emphasis is on understanding risks and controls rather than building systems. Still, you need enough technical knowledge to ask good questions, understand how a process works, identify weak points, and evaluate whether management’s explanations make sense.

A bachelor’s degree is expected, usually in accounting, information systems, or computer science. Beyond that, certifications can be valuable. The most recognized credential in the field is the Certified Information Systems Auditor. That certification shows that you understand IT auditing, governance, systems acquisition and development, and operations.

Employers also look for practical skills. You should be comfortable with documentation, process walkthroughs, control testing, report writing, and interviewing people. Professional skepticism is essential, because you can’t just accept a process description at face value. You have to verify it.

What Kind of Person is a Good Fit for IT Auditing?

The best fit is someone who’s very organized and willing to wade through a lot of detail to figure out how processes really work. A disorganized person would absolutely struggle in this environment.

In addition, a strong IT auditor can move back and forth between the details and the big picture. They can inspect an individual control, but they also understand why that control matters to the organization. For example, they can see how a weak access approval process might create risk for system security. That broader perspective makes you a more effective auditor.

In terms of personality, IT auditors often do well when they’re calm and persistent. Auditors often have to revisit issues, request more evidence, and clarify vague explanations. To do that, they have to be patient. They also need confidence, because part of the job is delivering findings that other people may not enjoy hearing. I think the personality type is a bit like a detective working for the local police department.

The Preferred Work Environment

As for the preferred work environment, IT auditing tends to suit people who like a professional setting within a larger organization. There’s a mix of independent work and teamwork. You might spend part of the day reviewing documents and testing controls by yourself, and another part interviewing people or discussing findings with the audit team. So the role is a good fit for someone who likes focused analytical work but is also comfortable speaking with others and presenting conclusions.

It can also be a good fit for people who want a career that evolves over time. IT auditors are exposed to many parts of an organization, including finance, operations, and executive management. That type of wide exposure can lead to roles in running internal audit, or enterprise risk management, or operational management. In that sense, IT auditing is not just a narrow specialty. It can be a good starting place for a much broader career.

To wrap up, IT auditors evaluate whether an organization’s technology controls are well designed and working effectively. They help organizations manage risk, protect information, and support reliable operations. The people most likely to do well in this field are seriously focused people who understand systems.

Unclaimed Property Laws (#391)

ABP #391 - Unclaimed Property Laws

Steven Bragg

The Nature of Unclaimed Property

Unclaimed property is any asset that belongs to someone else, but which has been on your organization’s books, and unclaimed by that other party. It’s usually been sitting on your books because you can’t find the other party. Some common examples are uncashed payroll checks, dormant bank accounts, customer refunds, and dividend payments.

The main point is that the property still belongs to the owner, not your business. The owner’s rights have not expired. Instead, the owner has simply become inactive or can’t be reached. When that period of inactivity lasts long enough, the law requires that you transfer it to the state government. The period of inactivity varies by asset, and it’s called the dormancy period. Instead of permanently taking ownership of these assets, the state takes custody until the rightful owner appears. Which, to be fair, hardly ever occurs. Nonetheless, the state is technically safeguarding assets on behalf of the owners.

The Legal Environment

What is the legal structure behind this? It’s fragmented. There is no single federal unclaimed property law. Instead, each state establishes its own rules. They determine which types of property are covered, how long the dormancy period lasts before a business has to turn over the goods, and how the reporting process works. As a result, a business that operates in multiple states has to comply with potentially dozens of state-level statutes.

This can be a problem when some states have laws that are designed to give them priority over the rights of other states. To keep the state governments from competing for the same property, the Supreme Court came up with a set of priority rules, which are pretty simple. The first claim to unclaimed property belongs to the state of the owner’s last known address. So if you send a check to a supplier in Kansas and the supplier does not cash it, then the amount of that check will eventually go to the Kansas state government. If there is no address, then a secondary rule applies – which is that the property goes to the holder’s state of incorporation. So if your organization is incorporated in Montana, then the Montana government gets the money. These rules are critical, because they determine which state government gets the goods.

That second rule is really important, because any state that incorporates lots and lots of businesses has a right to their unclaimed property. And that state, obviously, is Delaware. It makes tons of money from corporation filing fees, but also from unclaimed property. As of last year, Delaware was raking in about $400 million annually from unclaimed property. We’ll get back to Delaware in a minute.

Types of Unclaimed Property

Now, let’s talk about the types of property that can be classified as unclaimed property. The largest category is cash and cash equivalents, which includes uncashed checks, refunds, deposits, and dormant bank account balances. Payroll checks are a big one. States usually impose a very short dormancy period on uncashed payroll checks, normally around one year.

An interesting one is customer credits. Businesses routinely issue small credits to customer accounts for various reasons, many of which are never used by customers – possibly because they don’t even know that the credits exist. Individually, these amounts may appear insignificant, but when aggregated across thousands of accounts, they can represent quite a large liability.

Here’s another one – gift cards. Some states exempt certain gift cards from unclaimed property reporting, while others require unused balances to the forwarded to the state after the dormancy period is over. Because the rules vary by state, businesses have to be really careful about tracking unused balances.

Or, how about securities? If dividend checks are uncashed or there is no contact with shareholders for an extended period of time, both the unpaid dividends and the underlying shares may have to be forwarded to the state. That’s a scary one. So make sure that you log into your securities account every now and then, or your broker might sell your securities and hand them off to the state. I’m not kidding.

Here’s a big one for insurance companies. If an insurer can’t find the beneficiary for a life insurance policy, or annuity payments, then – once again – the state gets the proceeds.

And an item for banks to be concerned about about is the contents of safe deposit boxes. If rental fees go unpaid and the bank loses contact with the customer, then the box may be opened and its contents transferred to the state. At this point, state governments might seem like giant vacuum cleaners that hose up all the unclaimed money in the economy, and that’s about right.

Holder Responsibilities

Let’s get back to the organizations that originally hold these assets, which are called holders. A holder is any entity that possesses property belonging to someone else. Almost any business can be a holder. Holders have a couple of responsibilities. The first is tracking dormancy periods. These usually range from one to five years, depending on the type of property.

Second, a holder has to perform due diligence before reporting property to the state. This usually involves sending written notices to owners, warning that their property will be transferred if they don’t respond. This gives owners one last chance to reclaim their property directly from the holder.

Next, holders have to file annual reports with the states that are entitled to receive the property. These reports list the owner’s name, last known address, the type of property, and the amount owed. There is a standard reporting format used by most states, but each state has a different reporting deadline, and different exemptions for what has to be reported. In other words, let’s make it complicated.

And finally, holders have to remit the property itself to the state government, usually in the form of an electronic payment.

Unclaimed Property Audits

Now, here’s the central issue. Lots of companies ignore unclaimed property laws, and may not even know that they exist. The trouble is that some states are quite aggressive about collecting these assets, and they use audits to enforce the law. They may have their own in-house audit staffs for this, or they may hire third-party auditors. In either case, the auditors are going to dig through the holder’s records for evidence of unreported property.

If your historical documentation isn’t good enough or it doesn’t exist at all, then the auditors can apply estimation techniques to approximate the amounts that should have been forwarded to the state in prior years. Plus penalties.

This can be a lot of money, and can come as quite a shock to businesses that were pretty loose about what happened to their unclaimed property. Which brings us back to Delaware. Some state governments have come to rely on the proceeds from unclaimed property to fund a good chunk of their ongoing operations, and so have very aggressive unclaimed property auditing operations. Which states might those be?

Delaware is considered to be by far the most aggressive. After that, we have New York, California, Texas, and Illinois. Other states that are known to be increasing their audit departments for unclaimed property are Pennsylvania, New Jersey, Massachusetts, Florida, and Michigan.

In short, the accounting department is the party most likely to be involved in keeping track of unclaimed property and reporting it. If you’re ignoring this area, and your business is in one of the states I just mentioned, then you might want to get your paperwork in order. And even if you’re located in some other state, don’t assume that an audit team will never show up at your door.

Accounting for Sports Complexes (#390)

ABP #390 - Accounting for Sports Complexes

Steven Bragg

The accounting for a sports complex can be surprisingly complicated. First of all, it can be really capital-intensive, especially as it was described by the listener. You have to excavate the swimming pool and then line it with concrete, and add water filtration systems. The ice skating rink requires refrigeration systems and an insulated floor, while you also have to buy weight machines and cardio equipment for the gym. And on top of all that, you have to build locker rooms, parking lots, and office space, and probably install air conditioning for most of the facility.

Asset Capitalization Issues

All of these expenditures have to be capitalized, with a range of different depreciation periods. For example, the building might be depreciated over thirty years, while the fitness equipment might only last a couple of years. The refrigeration system for the skating rink is probably somewhere in between.

Obviously, there’s going to be a lot of depreciation expense. If you wanted to, you could allocate the depreciation to each business area within the sports complex, to figure out profit levels by activity. This would be a nice activity-based costing project, where depreciation is assigned based on how much each asset is used. For example, the depreciation on the skating rink asset is charged straight to that activity, while the depreciation on the entire structure could be allocated to the skating activity based on the number of square feet that it takes up.

A related issue is how to account for expenditures related to these assets. For example, fitness equipment wears out all the time and has to be replaced, so that’s obviously recorded as an asset replacement. But what about draining the pool and resurfacing it? If doing so extends its useful life, then that expenditure is recorded as a fixed asset. If not, it’s an operating expense.

This type of facility experiences a lot of wear and tear, so there are likely to be lots of ongoing maintenance expenditures. In most cases, these are going to be charged to expense right away. And as the facility ages, maintenance expenses are likely to keep on increasing.

Revenue Recognition

Next up is revenue recognition. There can be a lot of revenue streams. You might have daily admission fees, monthly memberships, swim lessons, skating lessons, personal training, league rentals, event hosting, equipment rentals, and concessions. There are differences in how to account for each one.

For example, if someone buys a one-year membership in advance, then you have to spread the revenue recognition over a full year. Or, how about a package of lessons? Maybe someone buys a package of ten skating lessons. If so, you recognize one-tenth of the revenue after each lesson has been completed. And what if you have an Olympic-level team of pairs skaters that rent the ice rink at 5 a.m. every day? Well, the revenue recognition for that is time-based, with revenue being generated in increments every day. Concessions are the easy part – you just recognize the revenue at the point of sale. Those examples cover most of the main areas, but you’ll likely find all types of variations.

Operating Expenses

Let’s move to operating expenses. There will be a lot of fixed expenses. I’ve already mentioned depreciation, but there will also be insurance, property taxes, and salaries. Variable expenses will be substantial – including utilities, water treatment chemicals, maintenance expenditures, and part-time labor. Of those expenses, utilities will be really large. A lot is required for skating rink refrigeration, while the pool will need to be heated. From a management accounting perspective, it can make sense to track utilities by activity, to get a better feel for where the complex is making or losing money.

Labor is another major cost. Lifeguards, trainers, front desk staff, and maintenance crews are all involved. Again, try to assign these expenses to specific activities.

A related item is long-term maintenance contracts, which cover the skating rink refrigeration and HVAC for the entire facility. If this is prepaid, then the accounting is to initially record it as a prepaid expense, and then amortize it over the service period.

Inventory Accounting

Moving along, there’s inventory to account for. This includes merchandise for the concessions area, and might very well include shrinkage accounting if any of that inventory is damaged or stolen.

Control Issues

And then we have controls. A sports complex usually has a lot of foot traffic, with high transaction volumes and – even now – a fair amount of cash payments. Based on this setup, there is a risk of asset loss, which can come from the theft of concession inventory, cash at the front desk, or rental equipment. Or, for that matter, simply the loss of revenue from customers who are getting in without paying.

There are lots of possible controls, including the use of badge access to the building, using electronic payments instead of cash, and segregating duties to keep anyone accepting cash from also accounting for it. I could probably list a hundred possible controls. A key issue here is that the operating margins of a sports complex tend to be on the low side, so investing in expensive controls has to have a clear cost-benefit.

Key Reports

Next, let’s cover some of the key reports. Management will want to understand the profitability of each part of the sports complex, so – as I’ve been mentioning – it makes a lot of sense to figure out profitability by activity. Another report should cover capacity utilization. For example, the ice rink is expensive to operate, so management needs to understand its operating cost, and the percentage of time that it needs to be booked in order reach its breakeven point. Once its fixed costs are covered, any additional bookings are pretty much pure profit.

Another reporting issue is cash forecasting. Revenues could be seasonal. For example, the skating rink’s use will peak in the winter, while the pool’s usage will probably peak in the summer. If you can project their cash flows, you can figure out whether the facility can cover its cash requirements, month by month, throughout the year.

In short, the accounting for a sports complex is surprisingly complicated, because there’s a lot of infrastructure, high transaction volumes, and lots of different activities to be tracked.

Accounting for Private Foundations (#389)

What is a Private Foundation?

A private foundation a tax-exempt nonprofit organization that’s usually funded by one person or a family. It might very well have been funded with one large initial contribution, and it may be targeted at a specific issue, such as reducing child poverty, or maybe eliminating Malaria.

A private foundation is usually not directly involved in running actual charitable programs. Instead, its main activity is issuing grants to other parties that manage programs that are of interest to the foundation. Its main secondary activity is investing its remaining cash, which could be a massive amount of money.

Accounting for Private Foundations

From an accounting perspective, private foundations follow nonprofit accounting standards. They prepare the same financial statements that are required for any other nonprofit. These include a statement of financial position, a statement of activities, and a statement of cash flows. However, there’s a key difference. Most private foundations report all net assets as being without donor restrictions. This is because the founding donor typically retains control of the board, so externally imposed donor restrictions aren’t needed.

The statement of financial position for a private foundation is usually massively asset-heavy. Investments usually represent the vast majority of total assets, quite possibly over ninety percent. This means that the fair value measurement of those investments is maybe the single most important accounting issue whenever financials are prepared.

On the statement of activities, revenue is driven primarily by investment income rather than contributions. While additional contributions may be made by the founding donor from time to time, most foundations instead rely on earnings from their endowment. Investment income can vary a lot, depending on the nature of the underlying investments, so the reported income figure can bounce around quite a lot from year to year, depending on the circumstances.

The largest expense category for most private foundations is grants paid. Grants are recognized as expenses when the foundation becomes legally obligated to make the payment.

This usually occurs when a grant is approved by the board, even if the cash will be paid in a later period. This distinction is important, because grant approvals affect both the financial statements and regulatory compliance calculations – which I’ll get to in a minute.

In addition to grants, private foundations incur administrative expenses. These include investment management fees, legal and accounting services, governance, excise taxes, and general administrative support. Expense classification is also important because certain administrative expenses may count toward the foundation’s required charitable distribution, while others do not. Which brings us to one of the most critical accounting topics for private foundations: the minimum distribution requirement.

Private foundations are generally required to distribute about five percent of their average assets each year for charitable purposes. This requirement is calculated under tax rules rather than the accounting standards, but the underlying data comes directly from the accounting system. Grants paid, and in some cases certain administrative expenses, are treated as qualifying distributions.

From an accounting standpoint, this means that foundations have to maintain detailed records that distinguish qualifying distributions from non-qualifying expenditures. Any failure to meet the minimum distribution requirement can result in penalties, so this is a critical reporting issue.

Another unique accounting item is the federal excise tax on net investment income. This tax applies directly to investment earnings. Private foundations have to recognize excise tax expense as part of their operating results. This creates a direct link between investment performance and tax expense that doesn’t exist for most other nonprofit organizations. In other words, if you achieve a great return on your invested assets, you pay a larger excise tax.

There are some other issues that can impact the accounting function. Consider the situation – a rich person funds a private foundation, and may very well have a fair amount of control over it. Maybe they actually want to give away money for good deeds, but then again, maybe they’re just sheltering assets from taxation, and still want to use the money. Given this scenario, these foundations are subject to self-dealing rules that are designed to prevent insiders from using charitable assets for their personal benefit

These rules prohibit most financial transactions between the foundation and disqualified persons, which includes substantial contributors, foundation managers, and their family members.

Prohibited transactions include the sale or lease of property, loans, excessive compensation, and the furnishing of goods or services. The rules apply regardless of intent, meaning that even transactions made on fair market terms can constitute self-dealing. Violations result in excise taxes being imposed on the disqualified person and potentially on those foundation managers who knowingly approved the transaction. From an accounting perspective, this can mean that you’re in the best position to point out breaches of the self-dealing rules. Which could be sticky, if you’re going against the boss.

Private foundations are also subject to rules that limit excessive business holdings, to keep them from controlling for-profit enterprises. In general, a private foundation cannot own more than 20 percent of the voting stock of a business. If a foundation acquires excess holdings, it’s typically given a limited period to dispose of the excess before penalties apply. This is still an accounting issue, because the accounting staff needs to track investment holdings to make sure that ownership limits aren’t exceeded.

There are also rules about jeopardizing investments. These are investments that jeopardize a foundation’s ability to carry out its charitable purposes. For example, a foundation might have an investment strategy that uses a lot of leverage and so puts it at a higher risk of loss. This might be considered inconsistent with the financial position of the foundation and its charitable giving goals. In short, you can’t contribute to charity if you’ve lost all your money. A violation in this area results in excise taxes on both the foundation and foundation managers who knowingly approved the investment. This is less of an accounting issue, unless the finance function is under the control of the accounting department.

In short, the accounting for private foundations is not necessarily all that difficult from a technical accounting perspective. The most unique aspect is that the reports generated by the department are needed to keep the foundation from distributing too little money each year, or being fined for self-dealing, or excessive business holdings, or for using jeopardizing investments.

Accounting for a Private Equity-Backed Company (#388)

ABP #388 - Accounting for a Private Equity-Backed Company

Steven Bragg

Additional Accounting Duties

When a private equity firm takes over a business, the accounting department is no longer expected to focus on just the accounting basics, like issuing customer invoices and paying suppliers. Now it’s given some extra targets. The first set of targets is based on the new capital structure of the business. The new owners probably paid for the acquisition with some equity and a whole lot of debt. There could be multiple types of debt that were obtained from different lenders, and each one has different fees and repayment terms and covenants associated with it.

All of these new debt features may have their own accounting implications, including interest expense recognition, debt issuance costs, covenant tracking, and ongoing classifications between current and long-term obligations. Debt is probably now hogging the balance sheet, so getting the debt accounting right is critical.

This concern with debt also carries over into financial reporting – or, more specifically, covenant reporting. Lenders can get really, really twitchy when an acquired company with a big debt load starts to breach its covenants. This means that the accounting staff has to get into predictive accounting mode, and watch the covenants in advance to see if there are going to be any failures. If management is warned in time, maybe they can negotiate new covenants.

A further issue here is that the definitions of performance metrics used in covenant agreements might not be the same as what’s defined in the accounting standards. That means the accounting staff has to conform to the definitions being used by the lenders.

Another issue involves investors. Private equity people do not just want the basic set of financial statements. They’re trying to build the value of the business as quickly as possible, so that they can sell out for a whopping profit. To do that, they’re going to want a lot from the accounting department.

Above all else, they want to know if the company can make its scheduled debt payments. To do that, the accounting staff has to prepare detailed cash flow forecasts – possibly every single day. For this type of investor, life revolves around the cash flow forecast. The owners will want to know about debt service coverage, and how much excess liquidity the company still has – if any. This is especially important if the company doesn’t have consistent sales; if there’s a drop in revenue, maybe due to seasonal or business cycle factors, then the owners will want to see how that impacts the latest cash flow projections.

Financial Statement Acceleration

The next change is that the new investors are going to demand financial statements as soon after the end of the month as humanly possible, so they can spot issues and correct them. So if you haven’t implemented fast close procedures before, then expect to now. The new owners are going to want results within a couple of days of month-end. And on top of that, they may demand financials on a more frequent basis – maybe some sort of a soft close at the end of each week, where you skip doing any accruals. This is going to put a lot of pressure on the accounting staff, so you’ll need to be as efficient as possible. That means using lots of closing checklists, and accrual templates, and setting up automated processes wherever you can.

Variance Analyses

A new issuance that goes along with those financial statements will probably be detailed explanations for negative variances. Private equity people set difficult goals, so it’s entirely possible that the business is going to have lots of variances – of the bad kind. If so, the accounting staff will be expected to track down the causes of those variances, so that the new owners can take action. This can be fiendishly time-consuming, since the accounting staff may have to go all over the business, trying to track down variance issues.

Accounting Policy Standardization

Here's another item. A private equity company probably handles its portfolio of businesses in a standardized manner. For example, it might impose a standard set of accounting policies that cover things like revenue recognition, capitalization policies, and expense classifications to be used. These new policies might differ from the ones that the accounting department was already using. If so, this will change the accounting for some transactions, and also might make it difficult to compare current period performance to what was reported in prior periods. As a very simple example, a new accounting policy might decrease the capitalization limit from $10,000 to $1,000. If so, a lot more expenditures will have to be classified as fixed assets, which is going to boost the reported amount of depreciation expense.

Use of Non-GAAP Measurements

Another issue will be the use of measurements that don’t align with anything authorized by an accounting framework. A prime example is adjusted EBITDA, which lots of private equity firms like to use. EBITDA stands for earnings before interest, taxes, depreciation, and amortization, and each firm has its own set of adjustments to modify it even further. The accounting staff will have to reconcile the differences between  adjusted EBITDA and either GAAP or IFRS reporting, depending on what you’re using.

A variation on adjusted EBITDA is key performance indicators, or KPIs. Private equity people evaluate the company’s progress with KPIs. The exact metrics used will vary by industry, but they normally include revenue growth, gross margin, EBITDA margin, working capital efficiency, and one or more leverage ratios. The accounting department is responsible for ensuring that the data used to create these KPIs is accurate. And on top of that, the owners might expect KPI updates a lot more frequently than once a month. This is not a minor task. When it comes to importance, meeting your KPI targets is right up there with the cash forecast.

Exit Planning Documentation

And then we have exit planning. A private buyer very likely comes into its new acquisition on the first day with a plan for how it wants to exit the business. Maybe they plan to flip it to a strategic buyer, or maybe they want to take it public. Either way, they’re going to impose very high reporting standards on the accounting staff, so the financials they produce will be acceptable to buyers, or detailed enough to support going public.

Not only does this require more financial reporting, but also lots and lots of detailed supporting documentation, so there won’t be any questions about whether reported numbers are correct. As an example of this extra reporting, let’s say that the plan is to take the company public in a few years. If so, the accounting staff has to get started with segment reporting right now, so that it can produce historical segment reports when the IPO eventually happens.

Or, as another example, what if the plan is to spin off part of the business? If so, you’ll need to prepare financials for just that part of the business that’s going to be spun off, and may also have to go back in time to create the same reports for the past couple of years.

In short, accounting represents the reporting and feedback loop for private equity buyers. It’s expected to collect specific types of information and churn out reports on a very frequent basis. This can cause a lot of stress within the department, so some pushback is required.

If you’re the company controller, you should demand extra staff to support the additional work, and ask for investments in automation, if that will support what the private equity folks are demanding.

Dealing with an IRS Audit (#387)

ABP #387 - Dealing with an IRS Audit

Steven Bragg

When you receive an IRS audit notice, this is not necessarily a hair-on-fire moment. The IRS may not think that you’ve broken the law, but it’s likely that something in a recent tax return triggered their attention. Maybe it was some kind of statistical anomaly in one of your tax returns, or your reported numbers don’t align with the reporting from some third party. Or maybe your company was just randomly selected. Who knows – and I wouldn’t worry about it at this point. Right now, the most important issue is dealing with the audit.

Types of IRS Notices

Let’s start with the type of notice that the IRS sends.  It will state whether you’re subject to a correspondence audit, an office audit, or a field audit. A correspondence audit is conducted by mail, and usually focuses on one or two very narrow issues. An office audit requires you to bring records to an IRS office for review. And finally, there’s a field audit, which is the most intrusive; it takes place at your company location and involves a deeper examination of your records. I’m going to focus on the field audit.

Early Actions to Take

As soon as you receive the notice, notify the senior management team. They need to know what’s coming, and be sure to keep them updated as the audit progresses. Next, assign responsibility for IRS interactions to someone who understands how to deal with the IRS. If you’ve never done this before, it could make sense to bring in an outside advisor, like a tax attorney or a CPA, and route all communications through that person. By doing so, you’re creating a buffer between the accounting staff and the IRS examiner, which can reduce the risk of misstatements or off-hand comments that could get you into trouble.

If you take this approach, then you’ll need to fill out a power of attorney, which is IRS Form 2848, so that the IRS knows who to talk to. From that point on, the tax expert representing you is negotiating with the IRS on your behalf. This step is huge. The amount of money you spend bringing in an expert is nothing compared to what you might otherwise pay to the IRS in fees and penalties.

Document Preparation

Next up is preparing documentation. The IRS is going to want to see substantiation for your deductions, credits, tax positions taken, and so forth. They’re not going to accept a verbal explanation; they want proof.

To get this right, you’ll need to get a team together within the accounting department as soon as possible, and work with your tax expert to find the documents you need and get them ready for review. Waiting is not a good option, since you need to find out early on if you’re missing any documents, and so will need to reconstruct whatever’s needed. The longer you wait, or the fewer the staff assigned to this, the greater the risk that you won’t be prepared for the audit.

Next up, take a hard look at those documents to see if there are any potential weaknesses. For example, maybe your claimed maintenance expenses were really high, so see if some of the repair bill should have been capitalized. Or maybe there are loans to shareholders that should have been characterized as distributions instead. By going through this review process, you can anticipate an examiner’s questions, and come up with well-supported explanations. By going through this process, you may be able to avoid handing over documents that are irrelevant or maybe just confusing. You’re required to be truthful, but you’re not obligated to volunteer unrelated information.

Dealing with the Audit Team

Now, let’s say that the audit team shows up at your location. First of all, be respectful, and absolutely never be adversarial. Put them in a good, quiet office, preferably somewhat away from the accounting staff. And, importantly, talk to your staff in advance and designate who is allowed to talk to the IRS team; no one else talks to them. All documentation goes through the people who are designated to represent you.

When the IRS team is on-site, it’s following IRS audit procedures, and makes decisions based on the evidence that your people provide it. If the examiners think that this evidence isn’t sufficiently clear, they might request additional documents or explanations. Your designated tax expert should review each of these requests, and may decide to push back if the request appears to be overly broad; remember, it’s always in your best interests not to let examiners go rooting around in your business, so keep their focus as narrow as possible.

Negotiate with the Audit Team

At some point, the IRS team is going to reach some preliminary conclusions, which may result in significant payouts. If so, and if your tax representative disagrees, it’s time to offer alternative analyses that are based on the tax law or court cases. If your expert can deliver a well-reasoned argument, this could influence the examiner’s conclusions.

The examiner then issues a preliminary report. If you agree with it, then your management team settles with the IRS, and you make whatever the tax, interest, or penalty payment may be. However, you may disagree with some or all of the report. If so, you have a right to appeal the decision, which goes through the IRS Office of Appeals. It may be worth an appeal when there’s uncertainty in the tax law about your situation. Appeals officers will evaluate the appeal, and if there’s some risk that they won’t win in court, they might offer a settlement for a reduced amount. On the other hand, if they’re not willing to offer a settlement, it's likely that they think they have a solid court case; if so, you might want to shut down the appeals process and just pay up.

In addition, you might have the option to take the matter to U.S. Tax Court, or U.S. District Court, or the Court of Federal Claims, depending on the circumstances. Doing so is expensive and takes a lot of time, so you generally don’t want to take this approach unless there’s a large payment involved.

In addition, the amount of penalties paid could be up for discussion. The examiner may propose penalties for negligence, understatement of income tax, accuracy-related issues, or the failure to file certain information returns. If you can prove that the business demonstrated reasonable cause, then it may be possible to get penalties reduced or maybe even waived entirely. For this, you really, really need a tax expert on your side who has dealt with the IRS before. Don’t try to handle it internally – your staff does not have the expertise.

The Post-Audit Review

At this point, the audit is over, but you’re not done yet. Conduct a post-audit review. Begin by tallying up the cost of the audit, in terms of the cost of your outside representatives, and staff time, and taxes and interest and penalties paid. It’s probably a lot of money – which you could have saved if you had better accounting systems and oversight of your tax filings. This is a good time to discuss those upgrades.

A further thought - if your business routinely engages in activities that attract IRS attention, such as related-party transactions, large deductions, or international operations, then develop the documentation that supports your tax positions. Maybe dial back on your more aggressive tax positions. And certainly retain tax advisors who can keep you up-to-date on changes in the tax law, and provide tax opinions for your more complex transactions. By taking these steps, you’ll be in a better position to defend against the next audit, and maybe avoid one entirely.

In short, an IRS audit doesn’t have to be a crisis. It’s a structured process that requires a lot of staff time and expert assistance. Yes, you may end up paying out a fair amount of cash; but if you use the experience to improve your systems and tax-related decision-making, it’s less likely to be an issue again in the future.

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Accounting for Hospital Cost of Goods Sold (#386)

ABP #386 - Accounting for Hospital Cost of Goods Sold

Steven Bragg

How does a hospital determine its costs of goods sold for the medical products used in patient care?

Cost of Goods Sold Inclusions

The cost of goods sold as it relates to patients covers things like bandages, IV fluids, medications, artificial joints, and pacemakers that are either administered or implanted during a hospital stay. These expenses are not actually called the cost of goods sold. Instead, they’re listed in the income statement as medical supply expense, or maybe as the cost of patient care supplies.

Another consideration is which items are not included in the cost of goods sold. That would be things like linen, reusable equipment, and capital assets – such as ventilators, infusion pumps, or that Bair Hugger that I just mentioned.

Cost of Goods Sold Process Flow

The foundation of the cost of goods sold calculation is the same as what you’d find in any other organization. These items are received and logged into inventory, and then charged to the cost of goods sold when they’re used. The difference from other businesses is that the cost of goods sold is usually calculated on an individual department basis. This means that you have a cost of goods for Emergency, and Surgery, and the pharmacy, and so on. These cost of goods figures are then rolled up into a single cost of goods sold total for the entire hospital.

Inventory Tracking Systems

Let’s talk about the inventory tracking systems being used. For anything remotely expensive, a perpetual inventory tracking system is used that monitors the exact quantities on hand. Or, for anything cheaper, such as gloves, you use a periodic inventory system, where items are ordered in bulk and only reviewed at longer intervals; in this case, there’s no need to be exactly correct in regard to how many units are on hand. If you run out, just go back to the supplies area and bring out another box.

Cost Assignment Processes

Now – how does a hospital figure out exactly which costs are assigned to each patient? After all, they have to bill the cost to the insurer. There are two ways to do it. One is with a charge capture system, which is the most common. With this approach, most medical products used on a patient have a corresponding charge code. So, for example, when nurses open a sterile kit or administer a medication, they scan the item and charge it to the patient. This creates a charge for the billing, and a consumption record for supply cost tracking. If the staff follows the scanning procedure, then this is a very accurate approach.

But, it’s not very effective for high-volume, low-cost items like gloves or gauze. In these cases, a hospital uses an allocation method, and assigns an average cost to patients for each day they’re in the hospital. Alternatively, the hospital could charge a standard rate that’s based on the procedure; for example, the supplies used during a colonoscopy differ from the supplies used for a pacemaker implant.

In short, these two approaches represent a blend of accuracy, with the charge capture system, and practicality, with the allocation system.

Standard Cost Usage

Next up, what about how costs are tracked? Hospitals typically track supplies using a standard costs, which is a predetermined estimate that should be fairly close to the actual cost. Standard costing simplifies pricing, so that a hospital is consistently charging the same amount to a range of patients when the same supplies are used.

It’s not always that easy to keep a reasonably accurate standard cost on file, for a couple of reasons. First, there may be contracts with suppliers, who change their prices whenever a new contract takes effect; if so, you have to adjust the standard cost file. Or, the hospital might be due for a rebate, but only after it achieves a certain volume of purchases.

A variation on the concept is called GPO tier advancement. GPO stands for group purchasing organization, and it refers to a cluster of hospitals that get together and order in bulk from a set of suppliers. Whenever the purchasing volume of the group exceeds a certain threshold value, the hospitals in the group advance to a higher tier, where the supplier prices are lower.

For example, Tier 1 might be base pricing for low-volume purchasers, while Tier 2 represents an improved discount, and Tier 3 is the best possible discount. Whenever there’s a change in tier, the associated standard costs have to be changed. This can involve a lot of reconciliation work, since a fair number of items that are still in stock were priced at the old standard cost, and now any additional items being purchased are coming in at a new standard cost.

Variance Analysis

As a further complication, hospitals have to adjust back to actual costs when they prepare financial statements. The difference between the total of these standard and actual figures is then recorded as a variance in the income statement. Ideally, management wants to see a purchase price variance, as well as a usage variance which shows how unit usage levels varied from expectations.

The Importance of the Cost of Goods Sold

Why is all of this important in a hospital? There are a bunch of reasons. First, the management team needs it to figure out the profits by service area, such as orthopedics or cardiology. They also need it to negotiate reimbursement rates with insurers. And, like any other business, they need to understand where supplies are being wasted or lost. Medical product waste may involve expired items, supplies that were opened but not used, and quite probably undocumented consumption.

And on top of that, there may be regulatory compliance issues, such as the extremely rigid tracking controls that a pharmacy has to impose on any controlled substances, like Oxycontin.

In short, hospitals use a mix of charge capture and cost allocation systems, use different inventory tracking systems to arrive at a cost of goods sold, and calculate that cost separately for different service areas within the organization.

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Accounting for CDFIs (#385)

ABP #385 - Accounting for CDFIs

Steven Bragg

What is a CDFI?

A CDFI is a financial organization that been certified by the U.S. Department of the Treasury to provide affordable loans and financial services to underserved communities. There are actually four types of CDFIs, but I’m going to focus on just one, which is nonprofit loan funds. What they do is issue loans to entities like small businesses, minority-owned startups, and affordable housing developers.

CDFI Accounting Issues

This might sound like a finance topic, but there’s an accounting component to it, as well. The key issue is that the loan fund is making loans into a segment of the economy that’s at higher risk of default. So in addition to the usual accounting, which is recording a note receivable and interest income, the accountant needs to pay a lot of attention to the collectability of those loans. The outcome is usually a fairly hefty loan loss provision.

For the accountant, the loan loss reserve can be a real challenge, especially during volatile conditions when the default risk goes up. Instead of waiting for actual defaults, a CDFI uses a forward-looking model that incorporates macroeconomic indicators like unemployment rates, inflation, and GDP contraction. It then adjusts the reserves as conditions worsen or improve.

On top of that, loans are grouped by risk characteristics, such as the borrower profile or the industry type, and each segment is stress tested using different economic scenarios. In essence, these “what if” models are used to ensure that the reserve is adequate if economic conditions really head downhill.

The goal is to ensure that a CDFI remains solvent and credible, and given its customer base, this is not easy.

And on top of that, the accountant will need to prepare the footnote disclosure for the financial statements. This includes a description of the methodology used to estimate credit losses, and the policy for charging off delinquent loans.

CDFI Funding Sources

Now, let’s talk about funding sources. A CDFI can get cash from three sources, which are grants, program-related investments, and debt.

It used to be quite common for a CDFI to receive grants from the CDFI Fund of the U.S. Treasury, but that group was just fired in early October by the Trump administration – all of them – so that funding source is gone, at least until the next administration comes along. That still leaves a few other sources of grants, which are local governments and foundations.

Keep in mind that a CDFI is a nonprofit, so it records grant funds as contributions. If a grant includes donor restrictions, such as only allowing the money to be used for loans to minority-owned businesses, then it’s recorded by the nonprofit as a net asset with donor restrictions.

Or, a foundation might lend money to a CDFI at below-market rates, which is done to support affordable lending. When this happens, the nonprofit records it as notes payable or long-term debt, depending on what the terms are.

In addition, if the organization is structured as a depository institution, then it also takes in customer deposits, which it can then loan out. These deposits are recorded as liabilities.

Because of the variety of funding sources, a CDFI has to be pretty careful about segregating the funds it receives, where some funds are unrestricted, and some are restricted and have to be monitored to ensure compliance with donor requirements.

CDFI Revenue Recognition

The revenue recognition for a CDFI is a bit different. Part of its revenue comes from interest income on its loan portfolio, but some of it comes from contributed revenue. As I already mentioned, a CDFI might receive a grant from a government or a foundation. When it does, it recognizes the grant as revenue; however, it can only do this when it meets the conditions associated with the grant. For example, a grant might be spread over three years, so the associated revenue can only be recognized over those three years. Or, if the grant requires matching funds from some other source, then there’s no revenue until the matching requirement is met.

Once loans are issued by a CDFI, the accountant then monitors the status of each loan, and can only record an interest income accrual if loans are being paid on time. Once they’re classified as nonperforming, then the accrual has to stop. This is usually when a loan payment is 90 days past due. When a loan is classified as uncollectible, it’s written off against the allowance for loan losses. If a borrower later repays part of that amount, it’s recorded as a recovery, which increases income in the period when the payment was received.

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Dealing with the Office of Foreign Assets Control (#384)

ABP #384 - Dealing with the Office of Foreign Assets Control

Steven Bragg

The Office of Foreign Assets Control

Accountants can become involved with the Office of Foreign Assets Control. This is very much a niche subject, because it’s primarily something that impacts nonprofit organizations within the United States that send money elsewhere. For example, when there’s a major earthquake in another country, or a hurricane, or a war, donors usually send their money to a nonprofit aid agency, which then turns around and sends the funds to the impacted areas. Seems simple enough, but it’s not.

At this point, a nonprofit runs into an issue that impacts both the accounting and finance functions. The Office of Foreign Assets Control, which is usually called OFAC, deals with sanctions and blocked persons. In addition, there’s the IRS Form W-8, which certifies the foreign status of the recipient of funds for tax purposes. We’ll get back to the W-8 in a minute.

Let’s start with OFAC. It’s part of the U.S. Treasury Department, and its job is to enforce economic and trade sanctions. In essence, it decides who American companies can do business with. That includes individuals, companies, banks, and even entire countries. The rules apply to every accountant who touches an international transaction.

Now, here’s where it gets tricky. OFAC defines “property” very broadly. It’s not just physical assets; it’s any financial interest or transaction that involves a sanctioned party. That means a single wire transfer or a loan repayment can become “blocked property” the moment it passes through a U.S. bank if it involves someone on the Specially Designated Nationals list, or even if a sanctioned party owns more than half of the entity receiving the funds.

For accountants working in nonprofits that have international operations, that’s a major concern. You might be trying to send money for food, medicine, or emergency shelters, but if any part of that transaction touches a blocked party, you could be required by law to freeze the funds and report the transaction to OFAC.

At the same time, there’s another layer to consider, which is the humanitarian exception. OFAC recognizes that sanctions can’t completely choke off aid that’s intended to save lives, so it includes specific authorizations called general licenses.

These allow certain types of humanitarian transfers, but the permissions are very narrow. The party sending the funds has to prove that the transaction really and truly fits the criteria. And if it doesn’t, a specific license has to be obtained before the funds can move.

In practice, this means that nonprofit accountants have to confirm that the recipient, its bank, and even its affiliates aren’t linked to sanctioned people. They have to verify that every payment is documented and justified within the scope of the license. This is boring as hell; it’s spreadsheets, and signatures, and a lot of discussions with compliance officers.

The Form W-8

Now, while all of that’s happening on the sanctions side, you also have to deal with the Form W-8. This is the IRS form that foreign parties have to submit so that they don’t automatically get hit with thirty-percent withholding on income coming from the U.S. There are several versions of the Form W-8 that I won’t get into, depending on the nature of the payment. Accountants see these forms all the time when paying foreign vendors, and consultants, or perhaps from someone receiving a grant.

The form is simple enough. It tells the IRS, “I’m not a U.S. taxpayer. Here’s where I reside. Here’s whether I’m entitled to treaty benefits.” Without it, the payer must withhold thirty percent and report the payment as if the recipient were unknown. So when a U.S. nonprofit pays a relief worker or a supplier who’s located abroad, that form determines whether the funds are fully available or reduced – a lot – by a withholding.

Documenting a Payment

The complication comes when both systems – OFAC and the IRS – overlap. Imagine that you’re the controller for an international relief organization based in Chicago. Your team is wiring half a million dollars to an NGO operating in a country that’s under partial sanctions. The NGO submits a Form W-8, claiming treaty benefits under its home country’s tax treaty with the United States. Everything seems routine, but your bank’s compliance department flags the transfer. It turns out that the NGO’s local banking partner is partially owned by a sanctioned government entity.

This is a problem. The W-8 tells you it’s a legitimate foreign entity for tax purposes. But OFAC says that, under the fifty-percent ownership rule, the banking chain could make this payment prohibited. You can’t process the wire until the situation is cleared. What began as a simple transfer to fund emergency medicine is now a complete mess.

If you’re that controller, you have to bring in an attorney to figure out whether the payment qualifies for a general license.

You document every step in your screening process. And, if necessary, you have to apply for a specific license from OFAC. Only when all of that work is done can you release the funds.

On the tax side, you’re not done yet. You have to verify that the Form W-8 is correctly filled out. This means verifying that the foreign tax identification number has been provided or marked as not legally required, and that the treaty claim matches the type of payment, and that the form was signed by someone with authority, and that it hasn’t expired yet. A W-8 is typically valid until the end of the third calendar year after it’s signed, unless there’s a change in circumstances. So if the foreign entity moves or changes ownership, you’ll need a new form within thirty days. So much fun.

When you think about it, both systems — OFAC and the IRS — are really about the same thing, which is verifiable integrity. They ask, “Who are you dealing with, and can you prove it?” OFAC wants to ensure that the money isn’t funding a prohibited activity. The IRS wants to ensure that tax obligations are properly allocated. Accountants operate right in the middle, which is a painful place to be. If these requirements become too onerous, I can see a lot of nonprofits deciding to not send money to any foreign entity that would be considered even remotely questionable. Not only is there a great deal of expensive bureaucracy involved, but a nonprofit could also be hit with fines that can reach into the millions – for just one violation. And, for that matter, a failure to collect or validate W-8s can make the payer liable for the taxes that should have been withheld.

In short, complying with sanctions and tax requirements is not easy, and it’s not going away. So, the next time you hear about an international organization rushing funds to a crisis zone, remember that there’s a team of accountants supporting the funds transfer. They’re verifying beneficiaries, confirming licensing, reconciling W-8s, and ensuring that no money ends up where it shouldn’t.

And a final thought. Why did I focus on just nonprofits in this episode? For-profit organizations have to deal with these issues too, but there’s one important difference. For-profits set up supply chains in other countries, and once they’re set up, there isn’t really a whole lot more to worry about. But nonprofits are always sending money into disaster areas, and that involves making payments to different players on the other end all the time. Which brings up the issues that I’ve noted in this episode.

Accounting for Labor Unions (#383)

ABP #383 - Accounting for Labor Unions

Steven Bragg

A labor union is officially defined as a collective organization of workers that negotiates with employers over pay, benefits, and working conditions. The overall intent is to give workers greater bargaining power.

Labor Union Tax Treatment

Legally, a labor union is organized as a nonprofit entity under Section 501(c)(5) of the Internal Revenue Code. This is not the better-known 501(c)(3), where donations are treated as tax-exempt. Instead, Section (c)(5) lumps labor unions in with farm bureaus and agricultural cooperatives, where the intent is to improve the conditions of work – that would be unions – or of products – which would be the farm bureaus and cooperatives. For these types of organizations, Section (c)(5) provides a federal income tax exemption, but they are not classified as charities, so you cannot deduct any contributions to them.

Accounting for a Labor Union

So, let’s get to the accounting. A labor union has two main sources of revenue, each of which is tracked separately. The biggest is member dues, which are paid on an ongoing basis. Depending on the situation, they’re usually forwarded to the union by employers, which deduct the dues from member paychecks. The second largest source of revenue is initiation fees, which are charged when a new member joins the union.

All other forms of revenue are supplemental, which is to say that receipts may be few and far between. For example, a foundation might issue a grant to a union, or the union might earn interest on its investments. Or, the union might earn some modest revenues from the sale of merchandise or training programs. Maybe the most interesting one is the special assessment, where the union charges its members for a special activity, such as to increase the size of a strike fund, or to help pay for a lawsuit.

But out of all the revenue sources, the key one by far is member dues. This has got to be tracked separately, which is why – of course – there’s union management software. These systems have automated dues tracking that reconciles employer remittance reports with individual member accounts. The software also posts receipts to the general ledger. Some examples of these software packages are UnionWare and Union Impact.

Now as for operating expenses, I’ll only deal with the unique items. A labor union incurs a bunch of expenses in the area of representation and negotiation. This means paying for negotiators, grievance handling, and arbitration. This does not just involve the cost of labor – there’s also a significant expense for travel, and meeting facilities, and in specialized cases, the union might also need to pay consulting fees.

But there’s more. A union might also pay benefits directly to its members, of which a massive one is strike benefits during a work stoppage. And on top of that, a union might pay for training programs and educational assistance. The training cost may include holding workshops for members, as well as sending the staff to conferences and conventions.

In addition, unions like to engage in a lot of lobbying to influence legislation in their favor. This means incurring expenses for political action committees and lobbying.

And finally – one more unique area – unions can spend a lot of money on recruiting new members, which means paying for outreach campaigns, putting on events, and paying staff organizers. This is actually a really critical area for unions, since there is such a thing as member churn. You have to bring in enough new members to replace the ones that leave, which means that this expense can be substantial.

So, that covers revenue and expenses. What about accounting issues? The biggest one is always the tracking of member dues, since that’s where the bulk of their revenues come from. Dues reconciliations can be fairly hard, because you have to adjust for members who’ve changed employers, or who work multiple jobs, or who shift between full-time and partial-time status – all of which can impact their dues obligations.

Here's another accounting issue. Unions have lots of layers. There may be a local, which is a subdivision of a national union that represents workers in a specific area. Above the locals is the national union, and there might be an international organization above that. When this is the case, you have to allocate member dues between each of these organizational layers. And, while doing so, you also have to account for the transfer of funds between each of these entities.

Another accounting issue is the handling of funds. An accountant for a union might set up a strike fund to pay members during a strike, and a defense fund to pay for any number of member legal issues, and a political action fund, and a training fund. These are needed to ensure that funds are set aside for specific purposes, but are also needed to ensure that a union doesn’t break the law – which it will if it diverts strike funds to some other purpose, like lobbying.

Another unique accounting area relates back to all of those funds being spent on political action committees and lobbying. When you do that, you have to segregate these expenses in order to comply with campaign finance laws.

Labor Union Reporting

And along a similar line, the Department of Labor requires that unions sent it a very detailed annual report; the level of detail that has to be reported depends on the volume of receipts that a union receives. For example, if a union receives at least $250,000 in a year, then it has to file the most complex form, which is the Form LM-2; it requires information about receipts and disbursements, itemizations of the larger disbursements, employee compensation, and a bunch of asset and liability ending balances. The main issue here is that unions have more reporting requirements than other types of nonprofits, which can be a major administrative burden.

Labor Union Fraud Issues

I’ll touch on one more issue, because it appears in the news every now and then – which is the theft of funds from unions. Unions have an inherently difficult control environment, because they receive funds from many employers, and then disburse it at multiple levels. You could lock down the theft opportunities with a large accounting staff, but most unions are understaffed, and so don’t have enough people to watch over this.

As an example, several officials of the United Auto Workers union, including two former presidents, were convicted of embezzling millions of dollars of union funds between 2017 and 2021. Another example is the American Federation of Government Employees – the treasurer of one of its locals embezzled more than $80,000 of union funds in 2021. And then there was the financial secretary of a United Steelworkers local that embezzled more than $150,000 back in 2016. In short, yes – controls are a very major concern for unions.

Accounting for Wind Power (#382)

ABP #382 - Accounting for Wind Power

Steven Bragg

Asset Capitalization

The topic of this episode is the accounting issues for the wind power industry. Let’s start with the capitalization of assets. A wind power installation is comprised of turbines, blades, gearboxes, and towers. Turbines have a useful life of about 25 years, while the blades don’t last as long – usually in the range of ten to twenty years. The issue with blades is that they’re subject to weather damage, and so might have be replaced a couple of times over the life of a tower.

Gearboxes last for the shortest amount of time, usually in the range of seven to ten years, and require a lot of maintenance even during that period of time. And finally, the towers that support all of these other items can last for 25 to thirty years. They’re made of heavy steel, and so last longer than the other components.

Given the differences in asset lives, each of these asset types has to be recorded and depreciated separately.

Another issue, and one that’s similar to solar power installations, is the capitalization of interest costs. If you’ve incurred debt to pay for an investment in a wind farm, then you should capitalize the cost of the interest incurred during the construction period, and then depreciate it over the useful lives of the related assets.

Asset Impairment

A somewhat related issue is asset impairment, and this is where wind power can differ a lot from solar power installations. An issue that’s cropped up in just the past few days is that the current administration thinks that wind farms are not good, for a variety of reasons, and so is withdrawing its approval from a number of wind farms, especially off the coast. I won’t get into the reasoning, but the main point from an accounting perspective is that a withdrawn operating license means that an entire wind farm would then be inoperable, so that you’d have to write off the entire capitalized cost. All of it.

However, it’s not really that simple. You would write off a wind farm when it’s probable that the facility will not be operable – which could depend on the outcome of one or more lawsuits and regulatory challenges. And that might take years.

During that time, you’d have to get with your legal team to estimate the probability of the facility being shut down, and recognize impairment based on that analysis. This is more of a qualitative issue than a quantitative analysis, so whether an impairment should be recognized at all, and in what amount, can be really hard to determine.

But there’s more to asset impairment than just presidential disapproval. An initial site analysis for a wind farm might estimate a certain wind speed over a certain number of hours per year. If you then install the towers and find that the wind speeds are lower than expected, then that reduces the amount of revenue generated, which can trigger an impairment. And on top of that, you may find that there are mechanical failures, especially in regard to the blades and turbines. If so, you may have to write them off and install replacements.

Asset Retirement Obligations

Which brings us to asset retirement obligations. A wind farm operator will probably have to recognize a liability for the cost to dismantle a wind farm at the end of its useful life. Dismantling is not an option – a requirement to do so is usually built into the operating license.

This can be expensive, because you have to dismantle and remove some very large structures, and excavate the foundations, which can extend ten to fifteen feet underground. In addition, fiberglass blades can be very hard to recycle. This is because they’re made of a fiberglass and reinforced plastic composite, which makes them nearly impossible to melt down. Instead, they may end up in a landfill, or be shredded and used as a cement reinforcement.

You also have to remove underground cables, substations, and transmission tie-ins, and restore the land. And on top of that, the jurisdiction in which the wind farm is located might decide to tighten up its reclamation requirements at some point in the future, which can increase your obligation even more.

And, if the wind farm is located offshore, then the retirement obligation can be an order of magnitude greater, because you have to conduct seabed restoration, and remove underwater cables, and eliminate anything that could impact ship navigation.

Revenue Recognition

The next accounting topic is revenue recognition. A wind power provider earns revenue under a power purchase agreement, where it sells electricity to a customer, usually at a set price and for an extended period of time. Under this arrangement, revenue is recognized when the system delivers electricity to the customer. If a wind farm goes offline for any reason, such as when the wind speed drops, then there’s no revenue.

The business might also sell renewable energy certificates. As I mentioned in the last episode, a renewable energy certificate represents the environmental attributes of one megawatt-hour of electricity that’s been generated from a renewable energy source. So, when a wind farm generates electricity, it produces two outputs, which are the actual electricity and a renewable energy certificate, which certifies that the electricity was produced from a renewable source. These certificates can be sold separately from the electricity, so that some other organization can claim to have used the renewable energy even if they didn’t directly receive the electricity. This third party would use the certificate to either meet its own sustainability goals, or meet a regulatory requirement to use renewable energy.

Under these certificate arrangements, the producer of wind power recognizes the value of the certificates when the electricity has been produced. It usually records them as inventory that’s being held for sale, and values them at fair market value, which is the rate at which the certificates are trading in the local market. When it sells a certificate, it recognizes revenue when control over the certificate is transferred to the buyer.

Market prices for renewable energy certificates can have a lot of variability, even within a short period of time, so if the seller retains ownership of the certificates for an extended period, it might have to test them for impairment.

One more revenue issue is that the seller might sell both electricity and renewable energy certificates to the same customer. If so, it will need to break out how much of the revenue generated is associated with the electricity, and how much is associated with the certificates, and record them separately.

Expense Recognition

There are also a couple of expense issues to be aware of. Wind farms are typically constructed on grazing or farm land, where the landowner is entitled to a percentage of the proceeds from any revenue generated, rather than just being paid a fixed fee. If so, you’ll need to calculate the amount of revenue sharing paid to the land owner, which is recorded as an expense.

Another expense is leases on land use. This is usually structured as a very long-term lease that covers the entire estimated life of the assets installed on the land. If so, you’ll need to record a long-term lease obligation, which includes the right-of-use asset.

Accounting for Solar Power (#381)

ABP #381 - Accounting for Solar Power

Steven Bragg

I’m only going to cover businesses that set up solar panels and sell the resulting power into the power grid, not the panels installed on someone’s house.

Capitalization of Solar Costs

Let’s start with the obvious accounting item, which is capitalizing the cost of the panels. This includes the cost of not just the panels, but also any associated racking systems, and batteries, and inverters. In case you’re wondering, a solar panel produces direct current, and an inverter is needed to convert direct current into alternating current, which is what your typical power grid produces. But we’re not done capitalizing yet, because we also have to capitalize the installation cost, and permitting and inspection fees, and interconnection fees. The interconnection fee is the one-time charge to hook up the solar panels to the local power grid.

And on top of all that, if you’ve taken out a loan to pay for everything, then you’re supposed to capitalize the cost of the interest incurred during the construction process. In short, pretty much every initial cost is capitalized.

Depreciation of Solar Assets

There are also depreciation issues. Solar panels have a fairly long useful life, so they can be depreciated for anywhere from 20 to 30 years, but inverters and battery storage systems wear out sooner – anywhere from five to 15 years – so you have to record these assets separately and depreciate them over different periods of time.

Impairment of Solar Assets

A further issue is the impairment of solar assets. There are lots of issues that can cause impairment. For example, solar panels naturally degrade over time. The typical degradation rate is between 0.5% and 0.8% per year, which can be worse in a harsh climate where there are greater temperature extremes or higher humidity. If there’s a higher-than-expected rate of degradation, then you have to record an asset impairment.

And there are other issues that might trigger an impairment. For example, there might be a fire, or flooding. Or, for that matter, if there’s a decline in the tariff rate on solar panels, then the market value of the existing panels declines, which triggers an impairment. Another cause is technological obsolescence, which happens whenever more efficient panels become available.

And, for that matter, you’re going to have asset impairment if there’s a long-term drop in the demand for electricity, since that lowers the revenue you can potentially receive; this last one may not be so big of an issue if you’ve entered into long-term contracts to provide electricity at fixed rates. Nonetheless, given the long-term nature of this asset, there’s a pretty good chance that one or more of these triggering events could occur over the life of a solar asset. In short, an impairment charge is quite possible, if not likely.

Revenue Recognition

The next accounting topic is revenue recognition. A solar power provider earns revenue under a power purchase agreement, where it sells electricity to a customer, usually at a set price and for an extended period of time. Under this arrangement, revenue is recognized when the system delivers electricity to the customer. If the solar array goes offline for any reason, or if it’s cloudy, or snow covers the panels, then there’s no revenue. Which is why there are so many big solar installations in warmer areas where there aren’t many clouds – it’s all about the revenue.

The business might also sell renewable energy certificates. First of all, what are they? A renewable energy certificate represents the environmental attributes of one megawatt-hour of electricity that’s been generated from a renewable energy source. So, when a solar array generates electricity, it produces two outputs, which are the actual electricity and a renewable energy certificate, which certifies that the electricity was produced from a renewable source. These certificates can be sold separately from the electricity, so that some other organization can claim to have used the renewable energy even if they didn’t directly receive the electricity. This third party would use the certificate to either meet its own sustainability goals, or meet a regulatory requirement to use renewable energy.

Under these certificate arrangements, the producer of solar power recognizes the value of these certificates when the electricity has been produced. It usually records these certificates as inventory that’s being held for sale, and values them at fair market value, which is the rate at which the certificates are trading in the local market. When it sells a certificate, it recognizes revenue when control over the certificate is transferred to the buyer.

Market prices for renewable energy certificates can have a lot of variability, even within a short period of time, so if the seller retains ownership of the certificates for an extended period of time, it might have to test them for impairment.

One more revenue issue is that the seller might sell both electricity and renewable energy certificates to the same customer. If so, it will need to break out how much of the revenue generated is associated with the electricity, and how much is associated with the certificates, and record them separately.

Decommissioning Solar Assets

Another accounting issue relates to decommissioning solar assets, which means dismantling and disposing of solar panels at the end of their useful lives. This might involve recognizing an asset retirement obligation early on, which is adjusted based on your most recent best estimates of which the decommissioning will cost.

Decommissioning can be fairly expensive, for a couple of reasons. First, some solar panels contain hazardous materials, like cadmium and lead, which require special disposal operations. And on top of that, batteries contain all kinds of toxic materials. And second, the cost to recycle panels is fairly high, and for the parts you can’t recycle, there’s a landfill charge.

Accounting for Water Authorities (#380)

ABP #380 - Accounting for Water Authorities

Steven Bragg

The topic of this episode is the accounting issues pertaining to water authorities. This is not a small area, because there are about 150,000 water authorities of various sizes just within the United States. Even a smaller country may have a few thousand of them.

The Nature of a Water Authority

To begin, what is a water authority? It’s a government entity that’s responsible for managing the supply and distribution of water within a specific area. In some cases, it also includes wastewater management.

Enterprise Fund Accounting

So, let’s get into the accounting. These organizations are accounted for as enterprise funds, which means that they’re accounted for pretty much like private businesses, where they charge fees in order to recover their expenses.

Infrastructure Accounting

They tend to be really heavy on infrastructure investments, like dams, pumps, and pipelines, so a major part of the accounting is capitalizing the cost of these assets correctly and depreciating them over, in some cases, a really long time. To do this properly, you need to maintain detailed accounting records that support how each asset was valued, as well as any additions, retirements, and impairments.

And, as I just noted, all of that infrastructure is subject to impairment. If the service utility of an asset declines, you’re looking at an infrastructure impairment. For example, what if a water authority spends a few million dollars on a pipeline from a reservoir, and then there’s a drought? If the reservoir dries up, then the pipeline is useless, and you could be looking at a massive impairment charge.

Infrastructure Funding Sources

Another accounting issue relates to how that infrastructure is financed. This is usually through revenue bonds, where the authority pays back investors from the revenue it receives from the projects being funded. For example, you might issue $50 million in revenue bonds to finance the construction of a dam, and then pay back the investors from the fees charged to the users of that dam. This means that the accountant has to record the principal and interest portions of each payment made back to the bond holders.

An alternative form of financing for infrastructure could come from a government grant. These grants are classified as non-exchange transactions under government accounting, where the recipient has to recognize both revenue from the grant and the related asset. As the accountant, you have to make sure that the water authority is complying with the terms of the grant. For example, you might only be able to draw down the grant if the water authority incurs specific types of qualifying expenditures.

There’s an additional issue that arises when these grants come from the federal government. If so, and the grant is for at least $750,000 within a fiscal year, then the water authority has to undergo an audit. The intent is to make sure that the funds are used properly, but from the accountant’s perspective, it’s just one more paperwork issue to deal with. These audits can take a lot of time, since they also include an examination of controls.

Revenue Issues

A water authority makes its money primarily from user fees and connection charges. These fees are probably subject to approval by the local government, which could result in losses. This is more of a finance issue than an accounting issue, but if you’re handling the accounting, you’ll likely be spending a good chunk of your time documenting why the authority needs to increase its rates.

Another revenue issue is the manner in which revenue is recognized. This is accrual basis accounting, so you recognize revenue when it’s earned, not when cash is received from customers. The implication here is that you can’t release financial statements unless you’re pretty comfortable with the accuracy of your water usage tracking systems.

Pollution Remediation Obligations

A unique expense that a lot of water authorities have to deal with is pollution remediation obligations. For example, they might have to deal with the cost of replacing lead pipes. If so, the accounting is to recognize the estimated cost of these replacements as soon as they can be reasonably estimated. This can be a massive expense, so as the accountant, you may find that the local government is picking over your estimates to see how accurate they are. And that annoying picking will continue each year, as you update the estimates.

Retirement Plans

Another accounting issue is retirement plans. A water authority might participate in a public retirement plan, which means that someone else is administering the plan. As the accountant, you’ll be generating the related journal entries based on what the plan administrator is reporting to you.

Control Systems

And then we have systems of controls. Water authorities have to set up and monitor some unique controls. For example, you’ll need controls over the misreporting of water usage and the manipulation of meter data. And, from the perspective of the accounting software, you’ll need access controls over who can alter the rates being charged to customers. The purchasing side of the business needs a lot of controls, since water authorities can spend vast amounts on construction. There need to be controls over how supplier contracts are authorized, and whether contractors have actually finished the work for which they’re being paid.

I’ve only touched on the most unique accounting issues that you’ll have to deal with in a water authority. As a general observation, the main annoyance will probably be the degree of public oversight over customer billings and requests for rate increases, since these are issues that impact the voting public. If you’re the type of accountant who likes to work quietly behind the scenes, it could come as quite a shock when outsiders want to inspect your work, and maybe criticize it. Something to think about.

AI Tools for Accountants (#379)

ABP #379 - AI Tools for Accountants

Steven Bragg

The topic of this episode is artificial intelligence tools for accountants. I could go into the background of how AI models are generated, but what’s of more interest to practicing accountants is how to actually use these models in their day-to-day accounting activities. What I’m going to do is describe some of the products that are out there right now, so you can get an idea of what’s available.

AI for Financial Planning and Analysis Software

Let’s start with financial planning and analysis software, and I’m going to use Datarails as an example. What they’ve done is layer AI on top of their software, so it runs an automated trend and predictive analysis to spot issues that you might not otherwise see. That’s useful for flagging problem areas before they escalate. For example, it might spot sales cresting for a particular product way down in just one region, which you might not see by manually scanning the data – which means that you could then take steps to scale back on the inventory for that item in that particular region. In addition, it uses AI to automatically generate presentations from the underlying data. This can keep you from spending hours creating a PowerPoint presentation for upper management. So in this case, the AI component provides value by spotting trends and anomalies, as well as by saving time in constructing presentations.

Datarails is not the only company using AI in its financial planning and analysis products. Oracle and Planful have similar capabilities, and I’m sure you can find other products. The main issue here is that these are higher-end products, where customers expect these companies to be on the leading edge of innovation. So, unless you’re willing to spend a lot of money on software fees, you probably won’t have access to these features just yet. Over time, of course, a lot of these features will probably trickle down into less expensive products.

AI for Auditing Products

Let’s switch over to auditing products. All of the Big Four audit firms have auditing software with AI features. Deloitte operates Argus software, while Price Waterhouse has Halo, EY has Helix and KPMG operates Clara. Each one of these systems has an AI engine that reviews large datasets for risk scoring, and irregular transactions, and in at least one case, even scans client contracts to see if they’re dealing with revenue recognition correctly. The great advantage here is that these systems can scan the entire population of a client’s accounting data, rather than just a sample, which massively reduces audit risk.

Operating these systems is expensive, but it’s cost effective for the Big Four, since their clients are big and rich, and so can afford the fees.

There are similar systems available for smaller audit firms that can’t afford to develop their own systems in-house, such as Inflo Audit and Mindbridge AI Auditor. All of these systems are good at flagging unusual transactions, which reduces audit risk. And, some of them even auto-generate workpapers based on your past engagements. So in these cases, the AI component provides value by spotting anomalies, and by reducing the drudgery of creating workpapers. Which is pretty much the same general types of capabilities that we just saw with the financial planning and analysis software.

AI for Accounting Software

And what about standard, off-the-shelf accounting software? AI is starting to appear down at the low end of the market, where QuickBooks Online detects anomalies in your bank feeds, and can even predict when your customers are going to pay their bills – which is kind of nice for cash forecasting.

Lets try another lower-cost package – Zoho Books. It has a smart journal entry feature that recommends which accounts to charge transactions to, which is useful for recurring entries.

Okay, let’s move up market a bit, to Microsoft Dynamics. They have an AI feature that automates bank reconciliations. And NetSuite, which uses AI for automated payment approvals, and also uses AI to assist with matching incoming customer payments to outstanding invoices.

Let’s go way up-market. Oracle’s enterprise resource planning software has an AI feature that evaluates employee expense claims for policy violations or fraud. And let’s not forget SAP, which has a bunch of high-end features. It has predictive accounting, which projects future revenue and expenses using order data and historical trends. Or, and a personal favorite of mine, it uses AI for three-way matching, where the system automatically links supplier invoices with purchase orders and receipts – which can eliminate a pile of work in the accounts payable department.

If there’s one common feature that the AI applications have in accounting software, it’s drudgery elimination – which is to say that it doesn’t necessarily eliminate tasks, but it does present you with the likely best way to proceed – such as with a proposed recurring journal entry, or a proposed three-way match. You still have to review it, but the system now takes away a good chunk of the work. Over time, this may result in some reduction in the low-end work of the accounting department, but on the other hand, you may need better-trained people who understand how the systems work, and who are mostly interested in dealing with anomalies.

And finally, I just have to bring up an earlier prediction, which was in Episode 237, back in 2017, when I took a guess at how artificial intelligence might impact the accounting profession. I’m going to rate that one a swing and a miss. I predicted that artificial intelligence would be used to automate collection calls. Nope, none of the current collection software packages do that. Instead, they use AI to recommend which collection method will work best, and the best timing for contacting customers, and for suggesting follow-up strategies. Which all represent modest efficiency gains, but not the home run of turning over the entire collections effort to a computer. Which concludes my baseball analogies.

What I’ve just brought up represents what a bunch of product designers all think are currently the most cost-effective AI enhancements that can be applied to the accounting profession right now. As time goes by, I’m sure we’ll see more advances. So stay tuned.

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The Accounting PhD (#378)

ABP #378 - The Accounting PhD

Steven Bragg

Should you earn an accounting PhD? If you become an accounting professor, what are your options for going back into accounting practice?

The Accounting PhD Options

If you get a PhD in this field, the main career track is to be an accounting professor. You could get a job in something else, such as working with an audit firm or being an accounting manager. But if you do, consider whether the cost-benefit is effective. It will take a solid five years of work after getting a bachelor's degree, and possibly a master’s degree, too, and during that time your compensation is going to be pretty low. So, you’ll be trading away a half a decade of your life in exchange for a PhD.

So let’s talk about the roles for a freshly-minted PhD. I’ll leave the obvious one of being an accounting professor for last, and start with auditing. As I’ve pointed out in other episodes, the audit track at a major audit firm is designed to take in younger people and put them on a rigid path that either kicks them out or turns them into partners about 15 years later. So if you’ve already spent the minimum of an extra five years to pick up a PhD, you’ll already be well behind all those other youngsters. You might even be starting off as a staff auditor and reporting to people who are younger than you.

Next up. What about applying for a job as an accounting manager in the private sector? Sure, you could, but I’m not sure if there’s any advantage to having a PhD. Manager positions require a history of – well, managing – which you will not have built up while getting the PhD. If anything, having a PhD on your resume might even be off-putting for potential employers, since they won’t know if you’re planning to leave the job to go back to academia.

And then we have the accounting professor option. The good news is that there’s a shortage of professors out there, so you can probably get a job. Though a downside is having to move to wherever the university is located, so you might end up in a less desirable location. Compensation is a tough one to pin down. According to the job sites, you can start at under $100,000 and go over $200,000, while the mid-range is somewhere around $125,000 to $175,000.

In short, the only realistic career track for an accounting PhD is to become a professor. For any other adjacent career tracks, having a PhD doesn’t provide you with any particular advantage, and if anything, it could be a hindrance.

I’m not trying to argue a case not to get a PhD, though. If you like to teach, then this could be perfect for you. And especially if you like taking your summers off. And if you can get tenure, then it’s a very stable job.

Moving from Academia Into Business

Next, what is the career path if you want to go from an accounting professor into accounting practice? As I’ve already pointed out, going into the private sector as a manager or going into an audit firm as an auditor don’t really give you any advantages. But there are a couple of possibilities.

One option is to go into a highly specialized area, like the accounting for derivatives. This might be the case where a large bank or an international company wants to have an on-site expert who can reliably deal with that very specific area. In essence, you’d be locked into a role as an expert, so there might not be a great chance at being promoted out into a more general role. The same option goes for a large audit firm. The Big Four always have people on staff who are expected to be absolute experts in very specific areas, and they’re expected to advise audit managers who have questions. These positions can pay quite well.

And then there’s the possibility of going out on your own as a CPA. A lot of accounting professors have CPA certifications, and if so, then this is an OK option. If so, putting “PhD” on your business card might attract a few more clients who might be impressed by it. On the downside, as a sole practitioner, you’ll have to attract clients, and that is not easy. You’ll likely be working with smaller clients, and to do even that, you’ll probably have to charge lower fees.

Which brings me to one more option, and maybe the best one for accounting PhDs. If you’re already a professor, then a common side gig is to do consulting on any number of topics. You can do research on topics that might attract the attention of large multinationals, and build up quite a good consulting practice on the side. If it eventually generates enough income, then you might be able to drop the professor position and just be a full-time consultant.

So, in short, an accounting PhD tends to result in exactly one job, which is accounting professor. And once you have it, you’d better like being a professor, because the options to get back out are rather limited – or at least very tightly defined.

Capital Budgeting in a Trade War (#377)

ABP #377 - Capital Budgeting in a Trade War

Steven Bragg

The topic of this episode is based on current events in the United States, and it is how to do capital budgeting during a trade war.

Trade War Issues

Let’s define the issues. When a tariff is imposed, the importer of the goods pays the tariff amount to the government, which means that it’s up to the importer to decide whether to absorb the cost of the tariff or to pass it along to the customer through a price hike, or a combination of the two. Given the massive amounts of the tariffs being imposed, it’s extremely likely that a large part of the tariff cost is going to be passed along to the customer. That’s the first issue.

The second issue is the duration and amount of the tariff. Usually, the tariff amount is low, and the probability of it changing is also low. In fact, tariffs usually only change when a new trade deal is approved by the government, which is pretty infrequent. And when a new trade deal goes through, tariffs generally go down, not up. But in this case, the tariff amount is high, and the volatility of the changes is also high, which makes for an extremely uncertain environment.

The third issue is how long the tariffs are likely to last. In this case, there’s a high probability that the tariffs will be eliminated or at least reduced at the end of the current administration, so we’re looking at a duration of somewhat less than four years. And keep in mind that this is a trade war, so other countries are imposing similar tariff amounts on goods being imported from the United States.

Capital Budgeting in a Trade War

Given these issues, how do you make a capital budgeting decision that makes any sense? The first consideration is that you’re looking at making an investment in what is now a high-cost, protected market. This means that the United States is the worst possible place to invest in large facilities from which you plan to export goods to other countries – and especially because it’s very likely that other countries are going to slap tariffs on any goods that you ship to them from the United States.

Instead, any investment should result in just enough capacity to meet local demand within the United States for the duration of the current administration. If there’s a large step cost in that facility that you’ll have to pay for to increase your capacity level, then the wise choice is to not incur the step cost, and instead keep the capacity level lower, so that you’re not investing too much. If that means that you lose some sales, then so be it.

Another consideration is that, if you’re producing goods within the United States, the cost of some of your inputs will probably increase, because some of them are coming in from outside the country, and tariffs will be getting charged on them. Since you’re the customer for these supplies, that means that your costs are going to go up. And when that’s the case, you’ll probably have to increase prices to your customers, which means that demand will decline. And that gets back to the need to keep your investment in new capacity as low as possible.

Your next consideration is how to spread the risk of loss, in case tariffs are later dropped, and cheaper competing goods start coming in from outside the country. There are a couple of options. First, consider outsourcing your manufacturing to someone who’s already constructed facilities within the country. Sure, the per-unit cost will probably be higher, but on the other hand, you’re not investing in new facilities. Another option is to enter into a joint venture deal with some other company, so that you can split the risk with them.

Another option is to pause all investments in the country until the current administration is out of office. After all, you can always invest in other parts of the world. The United States is responsible for about 15% of global trade, which of course means that 85% is everywhere else. So, a pretty safe option is to work on other capital investments elsewhere, and just avoid the uncertainty.

A lesser option is to sell off your investments in the country and get out entirely. This is an unlikely option, since a reasonable assumption is that the tariffs will go down or be eliminated in four years, and business gets back to normal. However, if the next administration decides to continue with the tariffs, then you’ll need to explore whether your business can realistically generate any profits within the country, and then maybe consider selling out.

Yet another possibility is to apply a really high discount rate to your net present value calculations for any proposed new investment, based on the extremely high risk level in the current environment. If you can come up with a wildly profitable investment that still generates a positive net present value, then have at it. This sort of investment would be quite rare – something that can start generating positive cash flow almost immediately, with a large return, so that the payback period is really short. The downside is that I have no idea how you’d even come up with a reasonably valid discount rate; it would probably be a wild-ass guess.

Here's another option. Spend the next few years investigating suppliers within the United States to see if they can reduce their prices and increase their quality levels to match what you’re already getting from your suppliers elsewhere in the world. I’m assuming that this might be a substantial effort, since you’d already be using adjacent suppliers if it made sense to do so. This sort of investment is relatively low, and it could take a couple of years to bring the new suppliers up to your standards. But by the time the trade war is over, you may have shorter supply lines, which reduces your transportation expenses, and which protects you in case there’s another trade war at some point in the future.

And one other possibility. You could treat this time as a good period for experimentation, and just invest in pilot projects to see if some new business ideas might be profitable. These investments would be small, so losing your investment would not be a big deal. And if any of the pilots work out, then you’d be well positioned to make larger investments after the trade war is over.

Related AccountingTools Courses

Budgeting

Capital Budgeting

Transfer Pricing (#376)

ABP #376 - Transfer Pricing

Steven Bragg

The Nature of Transfer Pricing

Transfer pricing refers to the prices at which assets are transferred between related businesses within a multi-national business. So for example, let’s say that you have a cell phone manufacturer that produces computer chips in South Korea, and then inserts the chips into phones that are assembled in Vietnam, with the phones then being sold in India. Which, in case you’re curious, is exactly what Samsung does.

The manufacturer has to set a transfer price at which it sells the chips made by its South Korean subsidiary to its Vietnam subsidiary. When setting this price, the number one decision is how you want to allocate profits between the subsidiaries. If South Korea has a higher corporate tax rate, then it makes sense to set a low price for its chips, so that the South Korean subsidiary reports a very low profit, and maybe no profit at all. That way, the income tax paid will be very low.

Meanwhile, the Vietnam subsidiary, which is subject to a lower tax rate, is buying chips for a low price, and so reports much higher profits. The result of this price setting is that the parent company, overall, is paying a lower tax rate.

Now, of course, if companies did this all the time, then the countries that impose higher corporate tax rates would never collect any money from their multi-nationals, since reported profits are all being shifted elsewhere. Which is why the national tax authorities impose what’s called the arm’s length principle, which states that a transfer price should be similar to what unrelated parties would agree upon in a free market. Well, that’s nice, but how does a government prove that a company is following the arm’s length principle? There are a bunch of ways.

Transfer Pricing Documents

First, most countries requires businesses to submit a set of transfer pricing documents. The names of these documents may differ by country, but there’s usually a master file, which contains the organizational structure and operations of the business, as well as its transfer pricing policies, and how it allocates income across jurisdictions. The master file helps tax authorities get a big picture view of an organization’s operations.

Next, there’s the local file. This contains country-specific details on intercompany transactions, and how the business justifies its transfer pricing.

It contains information about the nature and value of related-party transactions, and identifies who those parties are. It also identifies the transfer pricing methodology used, and why it was used. We’ll get into transfer pricing methodologies in a minute. The reason for this report is to give tax authorities a clear view of how profits are being allocated within their jurisdictions.

And finally, there’s the country-by-country report. This contains a breakdown of revenues, profits, taxes paid, and economic activity by country. Its useful for comparing recognized profit to the activity level in each jurisdiction; if there’s a high activity level but a low recognized profit, there’s a good chance that the government will be asking some questions.

All three of these reports are usually issued annually.

Advance Pricing Agreements

So far, this reporting is fairly passive. The business prepares it and sends it to the government in which it has operations. What does the government do with it? One option is the advance pricing agreement, or APA. This is a formal agreement between the business and the government that states in advance the transfer pricing methodology that the business is going to use, so that there are no surprises. In essence, both parties agree on what’s going to be a fair approach, and which transactions it’s going to apply to. These agreements are usually good for somewhere in the range of three to five years, and may be rolled forward without too much additional discussion.

A business might enter into an APA with just one government, which is called a unilateral APA, or it could enter into the agreement with several countries at once, which is called a multilateral APA. The advantage of having a multilateral one is that all parties agree on the pricing arrangement, which helps to avoid any disputes between the parties.

A further benefit of an APA is that a business is at less risk of being targeted by a government audit. These audits examine whether a company’s transfer prices are reasonable. If the government finds any evidence of accounting inconsistencies or manipulation, then the business is going to be hit with penalties and interest. Some countries impose double taxation on these adjustments, so they can be a really big deal.

General Anti-Avoidance Rules

Now, some organizations can get into some serious tax avoidance strategies that are technically legal, but which go against the nature of the underlying transactions. Governments deal with these situations using what are called general anti-avoidance rules.  These rules give tax authorities the power to override tax arrangements that are primarily designed to avoid taxes, and which lack genuine economic substance.

For example, let’s get back to that cell phone manufacturer. Let’s say that it sets up a subsidiary in a zero-tax jurisdiction with no employees or assets, and it routes most of its profits there through some complicated transfer pricing arrangements. Even if those prices seem justifiable on paper, tax authorities could say that the structure has no real business purpose other than avoiding taxes. Therefore, the tax people can ignore it and tax the company as if the income was earned elsewhere.

Transfer Pricing Methods

And, as I mentioned earlier, there are different approaches to transfer pricing – I’ll give you a quick summary of the main methods. There is the cost plus method, in which a subsidiary is allowed to add a markup to the costs that it has incurred, which results in a transfer price. Next up is the profit split method, which allocates the combined profits from the entire value chain to each subsidiary, based on each entity’s contribution to the final product. And then there’s the resale price method, which starts with the resale price at which a product could be resold to an independent third party, and then subtracts the gross margin that an independent reseller would earn to arrive at the transfer price.

Another option is the comparable uncontrolled price method, which compares the price charged between subsidiaries to the price charged to an outside party, to see if it’s reasonable. And finally, we have the transactional net margin method, which sets up a net profit margin relative to the most appropriate base, such as revenues, expenses, or assets related to an inter-company transfer.

I’m not going to explain the details for each of these methods – the point is merely to point out that there are a lot of ways to develop transfer prices, all of which are legitimate, and which can result in differing amounts of profits being recognized in each subsidiary of a multi-national company. So, given the number of options available, it should be no surprise that accountants pay a lot of attention to transfer pricing, and negotiating with governments to get their favored approaches accepted. Which could result in millions of dollars of tax savings.

The Transfer Pricing Career Path

One last item - the career path for an accountant working in this area. First, it’s a good niche to be in, both from the perspective of the company accountant and the government auditor, because both of them can positively impact the cash flows of their employers.

A company accountant can get into this profession by concentrating on cost accounting, while the path for a government auditor also includes cost accounting, but in addition, spending some time as either an internal auditor or as a public accountant, in order to gain experience with auditing work.

And one word of warning; this is a niche area, so you may have trouble getting promoted out of this field, on the grounds that you’re too valuable within it.

Related AccountingTools Courses

Essentials of Transfer Pricing